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Stock Market Powerpoint

Financial Markets and Institutions

Anthony Saunders • Marcia Millon Cornett

Fin an

cial M arkets

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S aunders

C ornett

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ISBN 978-0-07-803466-4 MHID 0-07-803466-3

E A N

The dawning of a new era in markets and institutions

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f i f t h e d i t i o n

Financial Markets and Institutions

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Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

FINANCIAL MANAGEMENT

Block, Hirt, and Danielsen Foundations of Financial Management Fourteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Tenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Seventh Edition

Brooks FinGame Online 5.0

Bruner Case Studies in Finance: Managing for Corporate Value Creation Sixth Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Second Edition

Cornett, Adair, and Nofsinger M: Finance First Edition

DeMello Cases in Finance Second Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations

Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management Tenth Edition

Kellison Theory of Interest Third Edition

Ross, Westerfield, and Jaffe Corporate Finance Ninth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Third Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Seventh Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Ninth Edition

Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS

Bodie, Kane, and Marcus Essentials of Investments Eighth Edition

Bodie, Kane, and Marcus Investments Ninth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Hirschey and Nofsinger Investments: Analysis and Behavior Second Edition

Jordan and Miller Fundamentals of Investments: Valuation and Management Sixth Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das Derivatives: Principles and Practice First Edition

FINANCIAL INSTITUTIONS AND MARKETS

Rose and Hudgins Bank Management and Financial Services Eighth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Seventh Edition

Saunders and Cornett Financial Markets and Institutions Fifth Edition

INTERNATIONAL FINANCE

Eun and Resnick International Financial Management Sixth Edition

Robin International Corporate Finance First Edition

REAL ESTATE

Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Third Edition

FINANCIAL PLANNING AND INSURANCE

Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Tenth Edition

Altfest Personal Financial Planning First Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills Third Edition

Kapoor, Dlabay and Hughes Personal Finance Tenth Edition

THE MCGRAW-HILL/IRWIN SERIES IN FINANCE, INSURANCE AND REAL ESTATE

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f i f t h e d i t i o n

Financial Markets and Institutions Anthony Saunders

Stern School of Business New York University

Marcia Millon Cornett Bentley University

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FINANCIAL MARKETS AND INSTITUTIONS, FIFTH EDITION

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2012, 2009, and 2007 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-0-07-803466-4 MHID 0-07-803466-3

Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Executive editor: Michele Janicek Executive director of development: Ann Torbert Editorial coordinator: Kaylee Putbrese Vice president and director of marketing: Robin J. Zwettler Marketing director: Brad Parkins Senior marketing manager: Melissa S. Caughlin Marketing specialist: Jennifer M. Jelinski Vice president of editing, design, and production: Sesha Bolisetty Lead project manager: Harvey Yep Senior buyer: Michael R. McCormick Lead media project manager: Rachel Townsend Media project manager: Suresh Babu, Hurix Systems Pvt. Ltd. Lead Designer: Matthew Baldwin Interior Designer: Matthew Baldwin Cover Designer: Laurie Entringer Cover Image: ©Getty Images Typeface: 10/12 Times Roman Compositor: Cenveo Publisher Services Printer: Quad Graphics

Library of Congress Cataloging-in-Publication Data

Saunders, Anthony, 1949- Financial markets and institutions / Anthony Saunders, Marcia Millon Cornett.—5th ed.

p. cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index. ISBN-13: 978-0-07-803466-4 (alk. paper) ISBN-10: 0-07-803466-3 (alk. paper) 1. Securities—United States. 2. Stock exchanges—United States. 3. Financial institutions—

United States. 4. Rate of return—United States. 5. Interest rates—United States. I. Cornett, Marcia Millon. II. Title.

HG4910.S28 2012 332—dc23 2011028460

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To Marty Gruber: a mentor and friend. —TONY SAUNDERS

To my parents, Tom and Sue. —MARCIA MILLON CORNETT

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Anthony Saunders

Anthony Saunders is the John M. Schiff Professor of Finance

and former Chair of the Department of Finance at the Stern

School of Business at New York University. Professor Saunders

received his Ph.D. from the London

School of Economics and has

taught both undergraduate and

graduate level courses at NYU

since 1978. Throughout his

academic career, his teach-

ing and research have special-

ized in financial institutions and

international banking. He has served

as a visiting professor all over the world, including INSEAD,

the Stockholm School of Economics, and the University of

Melbourne.

Professor Saunders holds or has held positions on the Board of

Academic Consultants of the Federal Reserve Board of Gover-

nors as well as the Council of Research Advisors for the Federal

National Mortgage Association. In addition, Dr. Saunders has

acted as a visiting scholar at the Comptroller of the Currency and

at the International Monetary Fund. He is editor of the Journal

of Financial Markets, Instruments and Institutions, as well as

the associate editor of a number of other journals. His research

has been published in all of the major finance and banking jour-

nals and in several books. He has just published a new edition of

his textbook, with Dr. Marcia Millon Cornett, Financial Institu-

tions Management: A Risk Management Approach for McGraw-

Hill (seventh edition) as well as a third edition of his book on

credit risk measurement for John Wiley & Sons. Professor Saun-

ders was ranked the 16th most prolific author out of more than

5,800 who have published in the seven leading Finance aca-

demic journals from 1953 to 2002 and was ranked first in the

top 16 journals (“Prolific Authors in the Financial Literature: A

Half Century of Contributions,” Journal of Finance Literature,

Volume 1, Winter 2005).

Marcia Millon Cornett

Marcia Millon Cornett is currently a professor of finance in the

School of Management at Bentley University. She received her

B.S. degree in economics from Knox College in Galesburg,

Illinois, and her M.B.A. and Ph.D. degrees in finance from Indi-

ana University in Bloomington, Indiana. Dr. Cornett has written

and published several articles in the areas of bank performance,

bank regulation, corporate finance, and investments. Articles

authored by Dr. Cornett have appeared in such academic jour-

nals as the Journal of Finance, the Journal of Money, Credit, and

Banking, the Journal of Financial Economics, Financial Man-

agement, and the Journal of Banking and Finance. In 2008, she

was ranked the 124th most published out of more than 17,600

authors and the number five female author in finance literature

over the last 50 years. Along with Anthony Saunders (John M.

Schiff Professor of Finance and for-

mer chair of the Department of

Finance at the Stern School of

Business at New York Univer-

sity), Dr. Cornett has recently

completed work on the seventh

edition of Financial Institu-

tions Management (McGraw-Hill/

Irwin). With Troy A. Adair, Jr. (Wilkes

University) and John Nofsinger (Washington State University),

she has also recently completed work on the second edition of

Finance: Applications and Theory and the first edition of M:

Finance (McGraw-Hill/Irwin). Professor Cornett serves as an

associate editor for the Journal of Financial Services Research,

the Review of Financial Economics, Financial Review, and Mul-

tinational Finance Journal. Dr. Cornett has served as a mem-

ber of the Board of Directors, the Executive Committee, and the

Finance Committee of the SIU Credit Union. Dr. Cornett has also

taught at Southern Illinois University at Carbondale, the Univer-

sity of Colorado, Boston College, Southern Methodist Univer-

sity, and Boston University. She is a member of the Financial

Management Association, the American Finance Association,

and the Western Finance Association.

ABOUT THE AUTHORS

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PREFACE

he last 20 years have been dramatic for the financial services industry. In the 1990s and 2000s, boundaries between the traditional industry sectors, such as commercial banking and investment banking, broke down and competition became increasingly global in nature. Many forces contributed to this break-

down in interindustry and intercountry barriers, including financial innovation, technology, taxation, and regulation. Then in 2008–2009, the financial services

industry experienced the worst financial crisis since the Great Depression. As the economic and competitive environments change, attention to profit and, more

than ever, risk become increasingly important. This book offers a unique analysis of the risks faced by investors and savers interacting through both financial institutions and finan- cial markets, as well as strategies that can be adopted for controlling and better managing these risks. Special emphasis is also put on new areas of operations in financial markets and institutions such as asset securitization, off-balance-sheet activities, and globalization of financial services.

While maintaining a risk measurement and management framework, Financial Mar- kets and Institutions provides a broad application of this important perspective. This book recognizes that domestic and foreign financial markets are becoming increasingly inte- grated and that financial intermediaries are evolving toward a single financial services industry. The analytical rigor is mathematically accessible to all levels of students, under- graduate and graduate, and is balanced by a comprehensive discussion of the unique envi- ronment within which financial markets and institutions operate. Important practical tools such as how to issue and trade financial securities and how to analyze financial statements and loan applications will arm students with the skills necessary to understand and man- age financial market and institution risks in this dynamic environment. While descriptive concepts, so important to financial management (financial market securities, regulation, industry trends, industry characteristics, etc.) are included in the book, ample analytical techniques are also included as practical tools to help students understand the operation of modern financial markets and institutions.

T

INTENDED AUDIENCE Financial Markets and Institutions is aimed at the first course in financial markets and institutions at both the undergraduate and M.B.A. levels. While topics covered in this book are found in more advanced textbooks on financial markets and institutions, the explana- tions and illustrations are aimed at those with little or no practical or academic experience beyond the introductory level finance courses. In most chapters, the main relationships are presented by figures, graphs, and simple examples. The more complicated details and tech- nical problems related to in-chapter discussion are provided in appendixes to the chapters located at the book’s Web site ( www.mhhe.com/sc5e ).

ORGANIZATION Since our focus is on return and risk and the sources of that return and risk in domestic and foreign financial markets and institutions, this book relates ways in which a modern finan- cial manager, saver, and investor can expand return with a managed level of risk to achieve the best, or most favorable, return–risk outcome.

Part 1 provides an introduction to the text and an overview of financial markets and institutions. Chapter 1 defines and introduces the various domestic and foreign financial markets and describes the special functions of FIs. This chapter also takes an analytical look at how financial markets and institutions benefit today’s economy. In Chapter 2 , we provide an in-depth look at interest rates. We first look at factors that determine interest rate levels, as well as their past, present, and expected future movements. We then review

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the concept of time value of money. Chapter 3 then applies these interest rates to security valuation. In Chapter 4 , we describe the Federal Reserve System and how monetary pol- icy implemented by the Federal Reserve affects interest rates and, ultimately, the overall economy.

Part 2 of the text presents an overview of the various securities markets. We describe each securities market, its participants, the securities traded in each, the trading process, and how changes in interest rates, inflation, and foreign exchange rates impact a financial manager’s decisions to hedge risk. These chapters cover the money markets (Chapter 5 ), bond markets (Chapter 6 ), mortgage markets (Chapter 7 ), stock markets (Chapter 8 ), foreign exchange markets (Chapter 9 ), and derivative securities markets (Chapter 10 ).

Part 3 of the text summarizes the operations of commercial banks. Chapter 11 describes the key characteristics and recent trends in the commercial banking sector. Chapter 12 describes the financial statements of a typical commercial bank and the ratios used to analyze those statements. This chapter also analyzes actual financial statements for representative commercial banks. Chapter 13 provides a comprehensive look at the regulations under which these financial institutions operate and, particularly, at the effect of recent changes in regulation.

Part 4 of the text provides an overview describing the key characteristics and reg- ulatory features of the other major sectors of the U.S. financial services industry. We discuss other lending institutions (savings institutions, credit unions, and finance compa- nies) in Chapter 14 , insurance companies in Chapter 15 , securities firms and investment banks in Chapter 16 , mutual funds and hedge funds in Chapter 17 , and pension funds in Chapter 18 .

Part 5 concludes the text by examining the risks facing a modern FI and FI man- agers and the various strategies for managing these risks. In Chapter 19 , we preview the risk measurement and management chapters in this section with an overview of the risks facing a modern FI. We divide the chapters on risk measurement and management along two lines: measuring and managing risks on the balance sheet, and managing risks off the balance sheet. In Chapter 20 , we begin the on-balance-sheet risk measurement and management section by looking at credit risk on individual loans and bonds and how these risks adversely impact an FI’s profits and value. The chapter also discusses the lending process, including loans made to households and small, medium-size, and large corporations. Chapter 21 covers liquidity risk in financial institutions. This chap- ter includes a detailed analysis of the ways in which FIs can insulate themselves from liquidity risk and the key role deposit insurance and other guarantee schemes play in reducing liquidity risk.

In Chapter 22 , we investigate the net interest margin as a source of profitability and risk, with a focus on the effects of interest rate risk and the mismatching of asset and liabil- ity maturities on FI risk exposure. At the core of FI risk insulation is the size and adequacy of the owner’s capital stake, which is also a focus of this chapter.

The management of risk off the balance sheet is examined in Chapter 23 . The chapter highlights various new markets and instruments that have emerged to allow FIs to bet- ter manage three important types of risk: interest rate risk, foreign exchange risk, and credit risk. These markets and instruments and their strategic use by FIs include forwards, futures, options, and swaps.

Finally, Chapter 24 explores ways of removing credit risk from the loan portfolio through asset sales and securitization.

viii Preface

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NEW FEATURES Key changes to this edition include the following: • Discussion of the 2008–2009 fi nancial crisis has been added throughout the book. Virtually every chapter includes new material detailing how the fi nancial crisis affected risk management in fi nancial institutions. • Appendix 1A describes events leading up to the fi nancial crisis, events occurring at the peak of the crisis, and events associated with the aftermath of the fi nancial crisis, in- cluding changes to fi nancial institutions, the impact on U.S. and world economies, federal fi nancial and fi scal rescue efforts, and regulatory changes. • Major changes proposed and implemented for the regulation of fi nancial markets and institutions are included where appropriate throughout the book. • New boxes highlighting “Notable Events from the Financial Crisis” have been added to chapters throughout the book. • New end-of-chapter problems have been included in several chapters. • Chapter 4 includes much discussion of the actions taken by the Federal Reserve and other international central banks during and after the fi nancial crisis. • Chapters 5 through 10 highlight the effects of the fi nancial crisis on various fi nancial markets and include discussions of the freezing of the commercial paper markets, the municipal default crisis, the mortgage market meltdown, and the role of credit derivatives in the fi nancial crisis. • Chapter 7 reviews the process that led to the conservatorship and proposed disman- tling of Fannie Mae and Freddie Mac. • Chapter 13 provides a synopsis of the Wall Street Reform and Consumer Protection Act of 2010 and the new deposit insurance coverage and premium rules, as well as an examination of the FDIC’s attempts to deal with the liquidity crisis, a discussion of the TARP Capital Purchase Program and stress tests on the major commercial banks in 2009, and a review of the new international capital standards being implemented for depository institutions worldwide. • Several chapters include discussions of major fi rms that have been lost or dramati- cally altered as a result of the fi nancial crisis (e.g., the failure of Bear Stearns, Lehman Brothers, and AIG; conversions of Goldman Sachs, Morgan Stanley, GMAC, and CIT Group to bank holding companies; the failure of Primary Reserve Money Market Funds; and the failure of CIT Group). • Chapters 22 through 24 discuss the role of derivative securities in the fi nancial crisis, including the roles of swaps (especially credit default swaps), collateralized mortgage, and collateralized debt obligations (CMOs and CDOs). • Tables and fi gures in all chapters have been revised to include the most recent data available.

ACKNOWLEDGMENTS We take this opportunity to thank all of those individuals who helped us prepare this and previous editions. We want to express our appreciation to those instructors whose insight- ful comments and suggestions were invaluable to us during this revision.

Preface ix

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Arabinda Basistha West Virginia University

Deanne Butchey Florida International University

Lucy Chernykh Bowling Green State University

Jon Chesbro Montana Tech

Wan-Jiun Paul Chiou Shippensburg University

Lee M. Dunham Creighton University

Donald Flagg University of Tampa

Victoria Geyfman Bloomsburg University of Pennsylvania

Lin Guo Suffolk University

William W. Hall, Jr. The University of North Carolina Wilmington

Wei He Mississippi State University

Taewon Kim California State University, Los Angeles

Adam Y. C. Lei Midwestern State University

D. K. Malhotra Philadelphia University

Khawaja Mamun Sacred Heart University

Christine Mooney Queensborough Community College

Ohannes G. Paskelian University of Houston-Downtown

Mitchell Ratner Rider University

Thomas W. Secrest Coastal Carolina University

John Thornton Kent State University

Wenyuh Tsay California State University San Marcos

Ying Wang University at Albany—SUNY

K. Matthew Wong St. John’s University

Sehyun Yoo Belmont University

We would like to thank the staff at McGraw-Hill for their help and guidance, especially Michele Janicek, executive editor; Kaylee Putbrese, editorial coordinator; Harvey Yep and Jill Eccher, project managers; Melissa Caughlin, marketing manager; Jennifer Jelinski, marketing specialist; Michael McCormick, senior buyer; Matthew Baldwin, lead designer; and Rachel Townsend and Suresh Babu, media project managers. We are also grateful to our secretaries and assistants, Alex Fayman, Jamie John McNutt, Sharon Moore, and Brenda Webb.

Anthony Saunders

Marcia Millon Cornett

x Preface

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The following special features have been integrated throughout the text to encourage student interaction and to aid students in absorbing and retaining the material.

CHAPTER-OPENING OUTLINES These outlines offer students a snap- shot view of what they can expect to learn from each chapter’s discussion.

LEARNING GOALS Learning goals (LG) have been added at the beginning of each chapter to serve students as a quick introduction to the key chapter material. These goals are also integrated with the end-of-chapter questions and problems, which allows instructors to easily emphasize the learning goal(s) as they choose.

BOLD KEY TERMS AND A MARGINAL GLOSSARY The main terms and concepts are emphasized throughout the chapter by bold key terms and a marginal glossary.

PERTINENT WEB SITE ADDRESSES Web site addresses are referenced in the margins throughout each chapter, providing additional resources to aid in the learning process.

WALKTHROUGH

Chapter Features

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“DO YOU UNDERSTAND:” BOXES These boxes allow students to test themselves on the main concepts presented within each major chapter section. Solutions are provided on the book Web site at www.mhhe.com/sc5e .

Pedagogical Features

IN-CHAPTER EXAMPLES These examples provide numerical demonstrations of the analytical material described in many chapters.

NOTABLE EVENTS FROM THE FINANCIAL CRISIS These boxes use articles pertaining to events during the recent 2008–2009 financial crisis to elaborate on chapter material.

INTERNATIONAL ICON An international icon appears in the margin to easily communicate where international material is being introduced.

“IN THE NEWS …” BOXES These boxes demonstrate the application of chapter material to real current events.

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EXCEL PROBLEMS These are featured in selected chapters and are denoted by an icon. Spreadsheet templates are available on the book’s Web site, at www.mhhe.com/sc5e .

SEARCH THE SITE Featured among the end-of-chapter material in most chapters, these Internet exercises weave the Web, real data, and practical applications with concepts found in the book.

END-OF-CHAPTER PROBLEMS AND QUESTIONS New to this edition, problems and questions in the end-of-chapter material now appear in separate sections. These newly defined sections allow instructors to choose whether they prefer students to engage in quantitative or qualitative analysis of the material. Selected problems also appear in McGraw-Hill’s Connect Finance online assessment product.

WALKTHROUGH

End-of-Chapter Features

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SUPPLEMENTS

FOR THE INSTRUCTOR

Instructors will have access to teaching support such as electronic files of the ancillary materials, described below, as well as other useful materials on the Online Learning Center at www.mhhe.com/sc5e .

• Instructor’s Manual Prepared by Tim Manuel, University of Montana, the Instructor’s Manual includes detailed chapter contents and outline, additional exam- ples for use in the classroom, and extensive teaching notes. • Test Bank Prepared by Jamie McNutt, Southern Illinois University, the Test Bank includes nearly 1,000 additional problems to be used for test material. • EZ Test Online A comprehensive bank of test questions is provided within a computerized test bank powered by McGraw-Hill’s fl exible electronic testing program EZ Test Online ( www.eztestonline.com ). EZ Test Online allows you to create tests or quizzes in this easy to use program.

Instructors can select questions from multiple McGraw- Hill test banks or author their own, and then either print the test for paper distribution or give it online. This user- friendly program allows instructors to sort questions by format, edit existing questions or add new ones, and scramble questions for multiple versions of the same test. Sharing tests with colleagues, adjuncts, and TAs is easy! Instant scoring and feedback are provided and EZ Test’s grade book is designed to easily export to your grade book.